India wades into messy index regulation tussle

Crypto shenanigans aside, it’s been a quiet start to the year. But something potentially important slipped out in the late-December doldrums: one of the most aggressive attempts to regulate the index industry.

This may seem niche and dull, but financial indices are incredibly important. As FTAV wrote last year, Morningstar estimates that the passive, index-tracking share of the $42tn open-ended investment fund industry has more than doubled over the past decade to about 35 per cent in 2022.

Even this understates their centrality, given how there are many non-fund index-tracking strategies, and how active managers are also far more (cough) index-aware than they were in the past. This is why some academics argue that index providers themselves have quietly become “gatekeepers that exert de facto regulatory power and thus may have important effects on corporate governance and the economic policies of countries”.

What to do about this — if anything — has been a low-key but hot topic in regulatory circles for some time now. Just last summer the SEC said it was considering whether to classify index providers as “investment advisers” and subjecting them to more onerous regulations.

This backdrop is why a proposal from India’s financial watchdog deserves attention. On December 28, the Securities and Exchange Board of India released this consultation paper on a regulatory framework for index providers. As it states:

2.9. The index providers disclose the methodology of index construction on their websites and there is an element of transparency. However, it is still possible to exercise discretion through changes in methodology resulting in exclusion or inclusion of a stock in the index or change in the weights of the constituent stocks. This has a significant impact on the return of the index funds. Thus, it can be implied that the role of stock selection being performed by the fund managers of index funds appears to have been delegated to the Index Providers to a certain degree. Inclusion or exclusion of a stock in the index may also have an impact on volume, liquidity and price of the stock.

2.10. There exists a possibility of conflict of interest arising in the governance and administration of indices / benchmarks due to presence of an element of discretion in management of indices including rebalancing of the index, in methodology adopted for construction of index including selection of stocks and in licensing of such indices. Conflict of interest could also arise as index administrators may not fully implement policies to ensure protection of sensitive information (e.g.; information regarding inclusion or exclusion of a particular stock from index could be misused).

Now, you might shrug this off as an issue only in India — hardly a superpower of finance. And this is just a consultation, after all, and Indian regulatory authorities aren’t exactly known for their alacrity.

But the implications of SEBI’s proposals are at least potentially far-reaching and extraterritorial. It envisages encompassing ALL financial indices, wherever they are created, as long as the users are in India.

As Alex Matturri, the former CEO of S&P Dow Jones Indices — one of the industry’s own “Big Three” alongside MSCI and FTSE Russell — put it in an LinkedIn post yesterday (our emphasis below):

India has become the latest country to propose regulation of index providers. In what might be the broadest regulatory framework yet, SEBI has proposed that any index used in India will require an index provider to establish an Indian legal entity and have minimum capital requirements. In addition, index providers will be subject to a mandatory external audit every two years to assure compliance with the IOSCO Principles.

What is striking with this approach is that any index used in India, whether for a product or as a performance benchmark will require registration while indices of Indian equities and bonds offered outside of India will not. Potentially, an index provider could be subject to regulation even if it does not know its index is being used. The breadth of this proposed regulation means that indices on non-Indian equities such as the S&P 500, MSCI EAFE and NASDAQ 100 will be regulated in India even though they are not regulated in their home market. This could lead to Indian regulators having extra-territorial powers and being able to reach into the US or European based operations of global index providers.

Furthermore, all input data must come from “regulated entities”. This is fine for equity prices that come from exchanges but creates significant issues for global fixed income indices and fundamental or ESG data used in thematics or other non-cap weighted indices. The risk to index providers will be that the current global patchwork approach to regulation will result in differing operating standards under the various regulatory regimes. Cost of regulatory compliance will continue to increase, and smaller index providers will become less competitive, potentially stifling competition.

Now, in practice we think the dangers of SEBI going studs-up against New York-based MSCI and S&P DJI and London-based FTSE Russell is probably small. It’s just not a sexy enough target to warrant the headache that it would also involve butting heads with regulators in the UK and US.

Our reading of the paper is also that SEBI is not proposing to require index providers to set up a locally-capitalised subsidiary in India. It only seems to require that the provider is a “legal entity incorporated under Companies Act in the country of origin”, with a minimum net value of Rs250mn (criteria which all the big international benchmarking companies fulfil).

But as an opening gambit, and given the broader murmurs about index provider regulation, SEBI’s initiative is still pretty intriguing.

The issues thrown up by just a few benchmarking companies de facto steering trillions of dollars around the world are simply becoming too big to ignore. Whatever SEBI ends up doing does will therefore undoubtedly be studied elsewhere.